Absolute Return Partners LLP Absolute Return Partners LLP

2012 Outlook2012 Outlook

December 2011December 2011

Part 1Part 1

The The EurozoneEurozone CrisisCrisis

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3

The eurozone crisis continues unabatedlyThe eurozone crisis continues unabatedly

Throwing money at the problem is no longer a viable option Throwing money at the problem is no longer a viable option –– the the numbers are simply too big;numbers are simply too big;

Germany holds the key to a lasting solution;Germany holds the key to a lasting solution;

It has to choose between:It has to choose between:

i.i. Monetisation;Monetisation;

ii.ii. Fiscal union;Fiscal union;

iii.iii. Withdrawal.Withdrawal.

Germany cannot say Germany cannot say ‘‘NeinNein’’ to all of them! to all of them!

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Bailing out Italy is not an optionBailing out Italy is not an option

Source: Morgan Stanley

The Italian government bond market is EuropeThe Italian government bond market is Europe’’s largests largest

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Italy must refinance Italy must refinance €€400 billion over the next 2 years 400 billion over the next 2 years

Source: Pioneer Investments

Italian sovereign refinancing needsItalian sovereign refinancing needs

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Is there room for monetisation?Is there room for monetisation?

Source: Banca d’Italia, Daily Telegraph

Italian monetary aggregates turning negativeItalian monetary aggregates turning negative

Part 2Part 2

EuropeEurope’’s Bankss BanksThe Biggest Story of 2012?The Biggest Story of 2012?

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European banks could be the main story of 2012European banks could be the main story of 2012

European banks must raise tier 1 capital ratios to 9% by 30 JuneEuropean banks must raise tier 1 capital ratios to 9% by 30 June 2012;2012;

EBA estimates a total of EBA estimates a total of €€106 billion of new capital will be required;106 billion of new capital will be required;

With virtually all banks selling well below (stated) book value,With virtually all banks selling well below (stated) book value, and with and with pressure on earnings, few are keen to raise new equity capital;pressure on earnings, few are keen to raise new equity capital;

The alternative is to delever;The alternative is to delever;

Morgan Stanley estimates Morgan Stanley estimates €€1.51.5--2.5 trillion of deleveraging over next 18 2.5 trillion of deleveraging over next 18 months (3months (3--5% of total assets);5% of total assets);

Barclays Capital puts the number as high as 10%;Barclays Capital puts the number as high as 10%;

Political pressure to continue domestic lending;Political pressure to continue domestic lending;

The only solution? Cut back on nonThe only solution? Cut back on non--domestic lending. domestic lending.

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Difficult to raise new equity when earnings are under pressureDifficult to raise new equity when earnings are under pressure

Source: Barclays Capital

2012 consensus earnings for European banks2012 consensus earnings for European banks

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Assets may have to shrink by as much as 10% to meet 9% targetAssets may have to shrink by as much as 10% to meet 9% target

Source: Barclays Capital

Banks in peripheral Europe must shrink the mostBanks in peripheral Europe must shrink the most

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Asia is exposed to European bank deleveragingAsia is exposed to European bank deleveraging

Source: Morgan Stanley

European banks have USD 1.6 trillion total exposure to Asia ex JEuropean banks have USD 1.6 trillion total exposure to Asia ex JapanapanAs of June 2011As of June 2011

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……but Asia is only a small part of total lending originated in Eurbut Asia is only a small part of total lending originated in Europeope

Source: Barclays Capital

European banksEuropean banks’’ geographical location of assetsgeographical location of assets

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Global trade is at risk from European bank deleveragingGlobal trade is at risk from European bank deleveraging

Source: Barclays Capital

Latin America trade finance loans, Q3 11

Spain and France dominate trade financeSpain and France dominate trade finance

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Eastern European exporters are very exposed to the EUEastern European exporters are very exposed to the EU

Source: Morgan Stanley

Emerging market exports to EuropeEmerging market exports to Europe

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Where will European banks be inclined to exit?Where will European banks be inclined to exit?

Source: Barclays Capital

Banks more likely to pull out where nonBanks more likely to pull out where non--performing loans are high performing loans are high

Part 3Part 3

Investment RecommendationsInvestment Recommendations

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Source: Morgan Stanley. Data as of 30 November 2011.17

ShillerShiller P/E ratios for Emerging Markets vs. S&P 500P/E ratios for Emerging Markets vs. S&P 500

Neither US nor EM equities look particularly cheap at this pointNeither US nor EM equities look particularly cheap at this point

US P/E ratios are 30% above the median and the emerging market discount has all but evaporated.

The value is in EuropeThe value is in Europe

Note: The Shiller PE ratio is calculated by dividing the price by the average inflation-adjusted earnings over the previous 10 years. 18

German and French valuations are back to 1982 levelsGerman and French valuations are back to 1982 levels

Source: Blackrock, Oriel Securities. Based on FTSE All Share Index as at 7 September, 2011. 2012 P/E = 8.9.

LongLong--term returns are negatively correlated with entryterm returns are negatively correlated with entry--point P/Espoint P/Es

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UK valuations consistent with attractive long term returnsUK valuations consistent with attractive long term returns

Investment Conclusion # 1Investment Conclusion # 1

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Overweight UK and stronger eurozone markets (ex financials) primarily for valuation reasons but also because a eurozone resolution is expected within 12 months;

Underweight US and emerging markets as economic growth will disappoint;

Underweight (most) commodities as EM weakness will take its toll on energy and metals in particular.

21Source: Kingdon Capital Management, JP MorganNote: Shaded areas indicate U.S. recession

High yield spreads are significantly above long term averagesHigh yield spreads are significantly above long term averages

High Yield Spread to 5High Yield Spread to 5--Year US TreasuriesYear US Treasuries

22Source: Kingdon Capital Management, JP MorganNote: Shaded areas indicate U.S. recession

Adjusted spreads are near record highs Adjusted spreads are near record highs

Spreads measured as % of total yieldSpreads measured as % of total yield

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Default rates are near 25 year lowsDefault rates are near 25 year lows

Source: Kingdon Capital Management, JP MorganNote: Shaded areas indicate U.S. recession

High Yield Default RateHigh Yield Default Rate

Investment Conclusion # 2Investment Conclusion # 2

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Corporate balance sheets in much better shape than sovereign and household balance sheets;

Overweight both US and European credit (ex financials);

Investment grade is attractive but the real value is to be found in high yield;

Focus on US high yield near term (less macro risk) but be prepared to switch to European high yield as 2012 progresses.

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Recommended weightings (next 12 months)Recommended weightings (next 12 months)

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